Will a price decline cause a tragic reduction in ag’s safety net?

It is clear that the current major safety net for production agriculture is the crop insurance program. In 2012, 88% of the insured corn acres were covered with some type of revenue insurance. Over 86% of the insured soybean acres, 83% of the insured wheat acres, and 70% of the insured sorghum acres were also covered with some type of revenue insurance. Most of the insured acres (over 82%) were covered with Revenue Protection (RP) that includes the harvest price. The Group Risk Income Protection (GRIP), GRIP with harvest price option, and RP with the harvest price excluded accounted for the remaining acres with revenue insurance coverage.

Many farmers and policy makers agree that the current revenue insurance contract provides an “adequate” safety net, but a concern is that the price risk is covered only within the growing season. The argument is that the base price set at planting time for revenue insurance guarantees could fall below the “cost of production”.

Table 1 shows how often the base price changes from the prior year’s base price. RP provides price/revenue protection within the year, but not across years. A “large” decline in base price from the prior year will cause a large decline in the current year’s revenue guarantee.

The average decline in the base price between years was 10.8% and would cause the revenue guarantee to decline by 10.8% from the prior year’s guarantee. However, this also assumes that the APH does not change. If the APH is higher than the prior year, then the reduction in the revenue guarantee will be less than the 10.8% caused by price alone.

The extremes are more important than the average. The largest reduction for the corn base crop insurance price was in 2009 with a 25.2% reduction from 2008. Soybeans suffered a 34.1% decline in the base price in 2009. Wheat had a 38.2% decline in price in 2010 from the prior year. These “large” price declines lower the revenue coverage, but fortunately these are rare events. There were three years when corn and wheat had a price decline of 20% or more from the prior year, and two years for soybeans.

Base prices can also increase from the prior year: on average 17.5% for corn and wheat, and 21.2% for soybeans. The largest base price increase for corn was 109% in 1974, following the 1973 Russian grain sale (100% for wheat), but more recently the largest increase base price for corn was 56.8% in 2007, 65.1% for soybeans in 2008, and 49.1% for wheat in 2009. When there is a large base price increase over the prior years, normally this will also cause significantly higher premium costs because of the higher price election and likely higher option price volatility.

Notice that often the large decline in base price follows years when there has been a large increase in the base price. The exception and the most difficult to manage would have been the price declines from 1982-1987. This was a period when farmers were under a severe financial crisis, causing many forced farm sales. Only the drought of 1988 changed the direction of price movement.

Summary. The other factor that will affect the revenue guarantee in the following year is a change in the APH yield. If the current year’s yield is low and replaces a higher yield from the 10-year history, then the revenue guantee will fall by more than just the price decline. However, APHs may also increase and that will reduce the impact of any price decline.

Clearly a lower base price in most cases will cause a decline in the revenue guarantee. It is rare for the base price to fall by more than 20% from the prior year, and the effect can be limited if the APH has increased. Over 93% of the RP corn contracts have a deductable of 20% or more. When combined with a low strike price, one has the argument for supplemental coverage or a target price. However, this is a rare event and any additional coverage could be targeted to cover this rare event.

Currently there is a limit on how much the APH can decline from the prior year and that limits some of the reduction in annual revenue guarantees. A public policy that would take the next step and limit the base price reduction from the prior year would target any “supplemental” program to the actual “hole” in the revenue insurance contract. For example if the price decline were limited to 10% from the prior year, it would only affect corn and wheat in 9 out of the last 38 years (10 years for soybeans). Even then, when the 10% cup had an effect that does not mean farmers would collect because they can always produce their way out of a loss.

Disclaimer: This web page is designed to aid farmers with their marketing and risk management decisions. The risk of loss in trading futures, options, forward contracts, and hedge-to-arrive can be substantial and no warranty is given or implied by the author or any other party. Each farmer must consider whether such marketing strategies are appropriate for his or her situation. This web page does not represent the views of Kansas State University or Drovers/CattleNetwork.